Creditors are often willing to negotiate a significant discount to settle a debt they know the customer can't pay in full. Millions of Americans buried in consumer debt took advantage of such a settlement offer last year.
Now it's time to pay taxes on the part of the debt that was forgiven.
"If you had any debt that was forgiven and the amount you saved was more than $600, the IRS considers that taxable income," said Bill Hardekopf, CEO of Lowcards.com. "You need to claim that on your tax return."
Let's say you owed the credit card company $15,000 and they let you settle the account for only $10,000. The $5,000 they forgave is taxable. If you're in the 15 percent tax bracket, you'd owe $750. Clearly, that's easier on your budget than the $5,000 you owed, but it could come as quite a shock if you didn't know about it.
In general, any creditor or debt collector who agrees to reduce the balance you owe by $600 or more is required to report that to the IRS. They file a form 1099-C and send you a copy.
"People tend to miss this because they didn't see any cash from the debt settlement and therefore they just assume this is not income," explained Certified Public Accountant Carmen Aguiar, CEO of The Aguiar Group in Bellevue, Wash. "This puts you at risk of being audited or hit with penalties and interest."
Credit counselors tell me some people are surprised to get the 1099-C form in the mail.
"A lot of these creditors and debt settlement companies don't disclose when the settlement is negotiated that the consumer can expect this tax liability later on," said Bruce McClary, director of media relations with Clearpoint Credit Counseling Solutions.
And there's no law that requires them to provide this information. So when a letter arrives from a past credit or collection agency, it's easy to assume that it's trash and throw it away.
"The way they find out that they owe taxes on the settlement is when they hear from the IRS asking why they didn't pay a tax liability reported by their creditor," McClary said.
The IRS expects to get 6.5 million 1099-C debt forgiveness forms this tax season. Tax preparers say it's important to make sure the information is correct.
"They are not always accurate," Aguiar told me. "They may show the entire debt, not just the amount that was forgiven."
The 1099-C is a complicated form. If you get one and don't understand how to read it, contact a tax professional. If the information is wrong, you need to contact the company and ask that a corrected 1099-C be filed.
"You have a right to dispute the 1099-C if you believe the information is incorrect and you have documentation of that," McClary advised.
Some types of forgiven debt are exempt from federal taxes. According to CreditCards.com these include: debts discharged in bankruptcy, mortgage debt forgiven in foreclosure, debts cancelled when you are insolvent and some student loan debt.